Question

Without using excel, solve : A company has identified two mutually exclusive cost saving projects. However, the equipment that will be required to realize the cost savings need an upfront investment of $250 million for both the projects. The annual cost savings expected from project 1 is 15% of the annual revenues and from project 2 is 12% of the annual revenues. The equipment used in both the projects have a useful life of 4 years. The firm has decided to employ a Straight Line Method (SLM) of depreciation and the ending period book value is zero for both the equipment. The firm expects to sell the equipment for projects 1 and 2 for $50 million and $100 million respectively at the end of 4 years. The year 1 revenue projected for this firm is $500 million, which is expected to grow at an annual growth rate of 5% for the subsequent years. The tax rate in the country is 15%. Which project would you choose based on a discounting rate of 10% ?

Answer 1

Project 1
Year	0	1	2	3	4
Annual revenue = Revneue in Year 1*(1+g)^n g =growth rate = 5%		500	500*1.05^1	500*1.05^2	500*1.05^3
Annual revenue = Revneue in Year 1*(1+g)^n g =growth rate = 5%		500	525	551.25	578.8125
cash outflow	-250
Annual cost savings-15% of revenue		75	78.75	82.6875	86.82188
less depreciation =250/4		62.5	62.5	62.5	62.5
operating profit		12.5	16.25	20.1875	24.32188
less taxes-15%		1.875	2.4375	3.028125	3.648281
after tax profit		10.625	13.8125	17.15938	20.67359
add depreciation		62.5	62.5	62.5	62.5
add after tax sale value = sale value*(1-tax rate) =50*(1-.15)					42.5
net operating cash flow	-250	73.125	76.3125	79.65938	125.6736
present value factor at 10% =1/(1+r)^n r=10%	1/1.1^0	1/1.1^1	1/1.1^2	1/1.1^3	1/1.1^4
present value factor at 10% =1/(1+r)^n r=10%	1	0.909091	0.826446	0.751315	0.683013
present value of net operating cash flow = net operating cash flow*present value factor	-250	66.47727	63.06818	59.84927	85.83676
Net present value = sum of present value of net operating cash flow	25.23
Project 2
Year	0	1	2	3	4
Annual revenue = Revneue in Year 1*(1+g)^n g =growth rate = 5%		500	525	551.25	578.8125
cash outflow	-250
Annual cost savings-15% of revenue		60	63	66.15	69.4575
less depreciation =250/4		62.5	62.5	62.5	62.5
operating profit		-2.5	0.5	3.65	6.9575
less taxes-15%		-0.375	0.075	0.5475	1.043625
after tax profit		-2.125	0.425	3.1025	5.913875
add depreciation		62.5	62.5	62.5	62.5
add after tax sale value = sale value*(1-tax rate) =100*(1-.15)					85
net operating cash flow	-250	60.375	62.925	65.6025	153.4139
present value factor at 10% =1/(1+r)^n r=10%	1/1.1^0	1/1.1^1	1/1.1^2	1/1.1^3	1/1.1^4
present value factor at 10% =1/(1+r)^n r=10%	1	0.909091	0.826446	0.751315	0.683013
present value of net operating cash flow = net operating cash flow*present value factor	-250	54.88636	52.00413	49.28813	104.7837
Net present value = sum of present value of net operating cash flow	10.96
Project 1 is better in comparison to project 2 As it results in greater NPV in comparison of NPV of project 2